Description
The purpose of this paper is to examine the impact of bank regulation and supervision on
bank development, efficiency and fragility over the period of 1999-2011.
Journal of Financial Economic Policy
Do bank regulation and supervision matter?: International evidence from the
recent financial crisis
Kangbok Lee Wenling Lu
Article information:
To cite this document:
Kangbok Lee Wenling Lu , (2015),"Do bank regulation and supervision matter?", J ournal of Financial
Economic Policy, Vol. 7 Iss 3 pp. 275 - 288
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Do bank regulation and
supervision matter?
International evidence from the recent
fnancial crisis
Kangbok Lee
Aviation and Supply Chain Management, Auburn University,
Auburn, Alabama, USA, and
Wenling Lu
Finance and Commercial Law, Western Michigan University,
Kalamazoo, Michigan, USA
Abstract
Purpose – The purpose of this paper is to examine the impact of bank regulation and supervision on
bank development, effciency and fragility over the period of 1999-2011.
Design/methodology/approach – The authors’ approach is based on a multivariate difference-
in-difference model which controls for potential endogeneity of the explanatory variables and
unobservable country-specifc effect. The paper investigates the changes of bank outcomes and a
country’s regulation and supervisory practices, in terms of capital regulation, supervisory power,
private monitoring, entry into banking requirements, overall restrictions on bank activities and
government ownership of banks in a sample of 53 countries with a total of 482 observations.
Findings – Empirical results indicate that greater capital regulatory requirements reduce bank
fragility, as measured by lower levels of non-performing loans but reduce bank effciency, as measured
by higher levels of net interest margin; supervisory practices that strengthen private sector monitoring
of banks improve bank development, as measured by bank private credit as a share of gross domestic
product; lower levels of non-performing loans are associated with greater enter-into-banking
requirements and less restrictiveness on bank activities; and greater government ownership of banks is
associated with both higher levels of net interest margin and higher levels of non-performing loans.
Overall, the fndings support Basel II’s frst and third pillars: capital requirements and private
monitoring.
Originality/value – This cross-country analysis provides evidence on which specifc regulatory and
supervisory practices work best in light of what was learned from the recent fnancial crisis.
Keywords Financial crisis, Financial institutions, Regulation and supervision
Paper type Research paper
1. Introduction
The global fnancial crisis of 2007-2009 was the most severe crisis since the Great
Depression, affecting banking systems in many countries. Kane (2009) argues that the
most important contributor to the fnancial crisis was a misguided regulatory
JEL classifcation – G38, G21, G28
The authors thank David Whidbee, Gene Lai, George Jiang and Que-Giang Tran-Thi for their
helpful comments and suggestions.
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/1757-6385.htm
Do bank
regulation and
supervision
matter?
275
Received17 March2015
Revised17 March2015
Accepted1 April 2015
Journal of Financial Economic
Policy
Vol. 7 No. 3, 2015
pp. 275-288
©Emerald Group Publishing Limited
1757-6385
DOI 10.1108/JFEP-03-2015-0019
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framework. Barth et al. (2012a) and C
?
ihák et al. (2012a and 2013) argue that weak
regulatory and supervisory frameworks contributed to the crisis and that
improvements to lessen the likelihood of another crisis can be made by such measures as
strengthening private monitoring incentives. In response to the recent fnancial crisis,
the regulatory reform agenda represented by Basel III as proposed by the Basel
Committee on Banking Supervision enhanced the level of complexity within the global
regulatory landscape[1]. However, it is not clear that the Basel III addresses the
fundamental cause of bank regulation failure.
There is a variety of different banking regulatory and supervisory structures and
some may be better-suited to improving bank development, performance and stability.
Importantly, newregulatory requirements will likely have a fundamental impact on the
shape of the business models that will be used by banks going forward. Our goal is to
empirically analyze the different regulatory and supervisory approaches in countries
around the world, and determine which approaches work best at improving bank
development, performance and stability. We address this issue by asking the questions:
Did regulation and supervision in some countries make a difference in terms of bank
development, effciency and fragility? To what extent have differential bank outcomes
in countries with greater stringency as regard bank regulatory and supervisory
practices led to changes? How was the performance of banks associated with stricter
bank regulation impacted before the fnancial crisis, during and after the fnancial
crisis? Answers to all of these important questions should be helpful to regulatory
policymakers in countries everywhere, as they consider and implement fnancial
reforms.
In general, our multivariate difference-in-difference (DID) regression results indicate
that in the pre-crisis period:
• greater capital regulatory requirements reduce bank fragility, as measured by
lower levels of non-performing loans but reduce bank effciency, as measured by
higher levels of net interest margin;
• supervisory practices that strengthen private sector monitoring of banks improve
bank development, as measured by bank private credit as a share of gross
domestic product (GDP);
• lower levels of non-performing loans are associated with greater
enter-into-banking requirements and less restrictiveness on bank activities; and
• greater government ownership of banks is associated with both higher levels of
net interest margin and higher levels of non-performing loans.
Interestingly, we fnd evidence that greater capital regulatory requirements enhance
bank development and increase bank effciency in the post-crisis period. Furthermore,
there is strong evidence that greater private monitoring is associated with lower levels
of bank development and higher levels of non-performing loans, suggesting that it is
less likely to foster the appropriate private market incentive framework in a weak
institutional environment where the private public sector lacks the ability to monitor
banks to better ensure bank development and stability after a crisis. Finally, greater
restrictiveness on bank activities is associated with higher levels of bank development,
but with higher levels of non-performing loans in the post-crisis period.
JFEP
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Our cross-country analysis provides evidence on which specifc regulatory and
supervisory practices work best in light of what was learned from the recent fnancial
crisis. Overall, the fndings support Basel II’s frst and third pillars of the capital
requirement and market-based disciplinary mechanisms. Moreover, stronger capital
requirements further enhance bank development, but market discipline or private
monitoring practices weaken development in the post-crisis period. The paper
contributes to the ongoing debate regarding appropriate regulatory reforms in the
banking industry to promote global fnancial stability by shedding additional light on
the extent to which the current regulatory and supervisory frameworks have an impact
on bank development, effciency and fragility.
The paper proceeds as follows. In Section 2, we review related literature on
regulatory and supervisory practices. Section 3 describes and discusses the data and
methodology used in our empirical analysis. Section 4 presents and discusses the results
of our analysis. Section 5 provides conclusions.
2. Literature review
There have been relatively limited data available on bank regulation and supervision
around the world. However, Barth et al. (2001) recently have provided the frst
comprehensive database to cover a wide range of characteristics associated with bank
regulation and supervision worldwide based on a survey of 117 national bank
regulatory and supervisory authorities. A limited amount of research has analyzed
bank regulation differences across countries and how they relate to bank development,
effciency and fragility. An important exception is the work of Barth et al. (2004), who,
for example, conclude that countries with bank policies that strengthen private
monitoring are associated with better bank development and performance. However, no
signifcant associations are found between stringent capital requirements, offcial
supervisory power, government ownership of banks and bank performance and
development, when controlling for other features of bank regulation and supervision.
Furthermore, Barth et al. (2008) point out that countries did not signifcantly change
their regulatory and supervisory structures suffciently for the better over the period of
1999-2008. However, it is not clear that these conclusions hold in the context of the recent
fnancial crisis. Therefore, we build on their work by examining whether the
relationships between banking development, bank performance and bank regulation
and supervision have changed in response to the recent global fnancial crisis.
Although Barth et al. (2012b) assess the relationship between regulatory and
supervisory practices and bank performance for Survey I in 1999 and Survey IVin 2011,
our cross-country analysis differs from theirs along the following dimensions. First,
unlike their analysis using data at one point in time, our analysis uses time-series data
over the period of 1999-2011. This allows us to identify trends and examine the evolution
of bank regulations over time[2] as well as increase our model’s explanatory power due
to a larger sample. Second, to illustrate how strengthened bank regulation and
supervision is related to bank performance, we classify a country in the upper 30 per
cent of strengthened bank regulatory and supervisory practices as “the treatment
group.” This allows us to compare the impact of bank regulation between two groups:
countries with either strong or weak regulations. Third, adding a time dummy allows us
to separate the impacts of bank regulation on bank outcomes during the pre-crisis and
post-crisis periods. Last but not least, we use multivariate DIDregression models which
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allow us to determine to what extent the regulatory and supervisory practices are
responsible for the observed changes in outcomes, compared to their studies which rely
on ordinary least squares regressions using each survey.
3. Data, methodology and explanatory variables
3.1 Data
The main bank regulatory and supervisory data used in this study are unique and are
becoming more widely used in banking research (see Barth et al., 2006, 2013, for a
detailed analysis and a detailed description of the construction of the indexes). We focus
on Basel III’s three pillars and three major indexes, introduced in the next section, in this
study[3]. The data on global fnancial indicators are from the World Bank Global
Financial Development Database (C
?
ihák et al., 2012b). The fnal sample is an unbalanced
panel with a total of 482 observations across 53 countries.
3.2 Variable defnitions
We discuss the variables used in the cross-country specifcations in this section. As
dependent variables, frst, we use bank development measured by bank private credit as
a share of GDP. It measures the level of fnancial development and refects the
intermediation of society’s savings into private sector credit. Second, bank effciency is
measured by net interest margin, representing the value of a bank’s net interest revenue
as a share of its average interest-bearing assets. Higher levels of net interest margins can
indicate banking sector ineffciency or greater market power or lower competitive
structure of the market that allows banks to earn higher margins. Third, bank stability
is measured by non-performing loans, representing the ratio of defaulting loans due 90
days or more to total gross loans. Higher levels of non-performing loans indicate lower
levels of loan quality, higher levels of bank fragility or corruption in lending.
As explanatory variables, we use six measures of the structure of bank regulation
and supervision. First, Capital Regulation (CR): Basel II’s Pillar 1, an index of the
stringency of bank capital requirements. It measures the extent of regulatory
requirements regarding the amount and the source of capital and whether the
authorities verify the source of capital (range: 0-10, with higher values indicating greater
stringency). Second, Supervisory Power (SP): Basel II’s Pillar 2, is an index of the power
of the offcial supervisory authorities. It measures the extent to which the authorities
have the power to take specifc actions to prevent and correct problems (range: 0-14, with
higher values indicating greater power). Third, Private Monitoring (PM): Basel II’s Pillar
3, is an index that measures the degree to whether there are incentives and ability for the
private sector to monitor banks (range: 0-12, with higher values indicating greater
private monitoring). Fourth, Entry into Banking Requirements (EBR), is an index of
regulatory entry barriers. It measures the strictness of specifc legal requirements for
obtaining a license to operate as a bank (range: 0-8, with higher values indicating greater
stringency). Fifth, Overall Restrictions on Bank Activities (ORBA), is an index of
regulatory restrictions of bank activities. It measures the limitations on the ability of
banks to engage in securities, insurance and real estate activities, and to own and control
non-fnancial frms (range: 4-16, with higher values indicating greater restrictiveness).
Sixth, Government-Owned Banks (GB), is the per cent of the banking system’s assets
government-owned.
JFEP
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As control variables, we take into account a number of country-specifc
characteristics. La Porta et al. (1998 and 1999) and Djankov et al. (2007 and 2008) fnd
that historically determined differences in legal origin help explain the differences in
fnancial development worldwide. Some studies also suggest that religious composition
and latitudinal distance from the equator infuence fnancial development (Stulz and
Williamson, 2003; Beck et al., 2003). Therefore, we include legal origin dummy variables
(English Common Law, German Civil Law, French Civil Law and Socialist Law); the
fraction of the population that is Catholic, Muslim and Protestant; and latitude in our
analysis. Furthermore, given that recent crises display some important differences from
earlier crises, and have been concentrated in advanced economies with large and
integrated fnancial systems (Laeven and Valencia, 2012 and 2013), we control for the
level of economic development in each country. We also include GDP per capita to
control for the level of economic development in each country.
Table I provides summary statistics for our selected variables. Countries in the upper
30 per cent of strengthened capital regulation, greater supervisory power, greater
private monitoring, greater entry into banking requirements, greater restrictions on
bank activities and greater government ownership of banks (countries in the treatment
group) account for 25.8, 33.1, 43.1, 71.0, 54.4 and 36.7 per cent, of our sample,
respectively.
Table I.
Summary statistics
Variable Mean SD Minimum Maximum
No. of
observations
Dependent variables
Bank development 76.299 50.273 9.617 269.280 482
Net interest margin 3.147 2.088 ?3.662 12.342 482
Non-performing loans 6.111 6.975 0.100 45.200 482
Treatments
Capital regulation 0.258 0.438 0 1 482
Supervisory power 0.331 0.471 0 1 482
Private monitoring 0.431 0.495 0 1 482
Entry-into-banking requirements 0.710 0.454 0 1 482
Overall restrictions on bank activities 0.544 0.498 0 1 482
Government-owned banks 0.367 0.483 0 1 482
Notes: This table reports summary statistics for the variables we use in our estimation; mean,
standard deviation, minimum, maximumand the number of observations values are displayed; the full
sample contains 53 countries and 482 observations over the period of 1999-2011; these 53 countries are:
Argentina, Australia, Austria, Belgium, Brazil, Canada, China, Colombia, Croatia, Czech Republic,
Denmark, Finland, France, Germany, Greece, Hong Kong, Hungary, Iceland, India, Indonesia, Ireland,
Israel, Italy, Japan, Kazakhstan, Kenya, Korea, Latvia, Lithuania, Luxembourg, Malaysia, Mexico,
Morocco, The Netherlands, Nigeria, Norway, Pakistan, Peru, Philippines, Poland, Portugal, Russia,
Singapore, Slovenia, South Africa, Spain, Sweden, Switzerland, Thailand, Turkey, Ukraine, the United
Kingdom and the United States; variable defnition: Bank development equals claims on the private
sector by deposit money banks as a share of GDP; Interest margin equals the value of a bank’s net
interest revenue as a share of its average interest-bearing assets; Non-performing loans equals the ratio
of defaulting loans due 90 days or more to total gross loans; countries in the treatment group are
countries in the upper 30% greater stringency regulation and supervision variables
279
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Table II provides the correlation matrix for the variables used in our analysis. These
correlation results are informative. First, greater bank development is signifcantly
correlated with less supervisory power, lower governmental ownership of banks and
fewer bank activity restrictions. Similarly, more effcient banking systems, as measured
by lower levels of net interest margin, are signifcantly correlated with less supervisory
power, lower government ownership of banks, fewer restrictions on bank activities and
fewer entry-into-banking requirements. Finally, bank fragility, as measured by higher
levels of non-performing loans, is signifcantly associated with weaker private
monitoring, stronger supervisory power, lower government ownership of banks and
greater restrictions on bank activities. However, these results do not take into account
other aspects of regulation and supervision due to their bivariate nature. Although some
regulatory and supervisory variables are signifcantly correlated with each other, some
of these correlations are relatively low. This suggests that it is important to consider a
broader variety of regulations and supervisory practices in assessing bank
development, effciency and fragility.
3.3 Methodology
We use Bank Regulation and Supervision Surveys to directly assess the differential
effect of bank regulation and supervision on bank development, effciency and fragility
in a sample of 53 countries during the period of 1999-2011. We implement a multivariate
DIDapproach to assess the change in bank outcomes in the pre-crisis and post-crisis for
weak and strong country-level bank regulation[4]. The regression model is expressed as
follows:
Y
it
? ?
0
? ?
1
CR
it
? ?
2
SP
it
? ?
3
PM
it
? ?
4
EBR
it
? ?
5
ORBA
it
? ?
6
GB
it
? ?
7
Time
? ?
8
CR
it
? Time ? ?
9
SP
it
? Time ? ?
10
PM
it
? Time ? ?
11
EBR
it
? Time
? ?
12
ORBA
it
? Time ? ?
13
GB
it
? Time ? ?X
it
? u
i
? ?
it
Where i, t refer to country and year, respectively. Y
it
is the dependent variables in
country i in year t. Time is a dummy variable that takes a value of one after the recent
fnancial crisis (year 2007-2011) and 0 before the recent fnancial crisis (year 1999-2006).
CR
it
, SP
it
, PM
it
, EBR
it
, ORBA
it
and GB
it
is a dummy variable in country i in year t that
takes a value of one if countries are in the treatment group and 0 if they are in the control
group[5]. X
it
is a set of variables to control for specifc characteristics in country i in year
t, described in the previous section. u
i
is all the country-specifc variation that is stable
over time. ?
it
is the error term. We identify the most suitable statistical models (pooling,
random effect or fxed effect) in our analysis by conducting two post-estimation tests:
the Breusch–Pagan Lagrangian multiplier (LM) and Hausman specifcation[6].
In our specifcation, the coeffcients for various bank regulation and supervision
practices measure the importance of regulation in the pre-crisis period. The coeffcients
for the interaction between regulation and time dummy show by how much the stricter
regulation countries (treatment group) changed compared to the less strict regulation
countries (control group) and compared to the pre-crisis period. As lower values of net
interest margin indicate higher levels of bank effciency and lower values of
non-performing loans indicate lower levels of bank fragility, the positive impact of
greater bank regulation in the pre-crisis period would imply a negative coeffcient for
these variables. Weakening (enhancing) impact of bank regulation after the recent crisis
JFEP
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Table II.
Correlation matrix
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would imply a positive (negative) coeffcient for the interaction between each of bank
regulation and the time dummy variable. However, the interpretation of the coeffcients
of bank development would be opposite compared to the one described earlier, as higher
values of bank development indicate higher levels of fnancial development[7].
4. Empirical results
4.1 Multivariate DID regressions results: bank development
We add the explanatory variables sets successively, starting with only three pillars of
the Basel II (Model 1). Model 2 adds both entry-into-banking requirements and overall
restrictions on bank activities. Model 3 includes government ownership of banks. The
results of bank development and bank regulatory and supervisory practices are shown
in Table III. First, we fnd a weak association between capital regulation and bank
development during the pre-crisis period; however, analysis of the post-crisis period
shows that strong capital regulation enhances bank development. In general, our results
show that, in total, bank development is positively associated with strong capital
requirements. This link is robust after simultaneously controlling for a broad aspect of
regulations. Second, we fnd weak evidence that bank development is negatively
Table III.
Multivariate
difference-in-
difference regression
analysis: bank
development
Department variable: bank
development (1) (2) (3)
Capital regulation (CR) ?3.45 (3.58) ?1.290 (3.697) ?1.424 (3.727)
Supervisory power (SP) ?0.611 (3.186) ?0.508 (3.186) ?1.002 (3.232)
Private monitoring (PM) 5.581* (3.019) 5.816** (3.055) 6.408** (3.095)
Entry-into-banking requirements
(EBR) ?3.505 (3.094) ?2.315 (4.217)
Overall restrictions on bank
activities (ORBA) ?0.601 (2.849) 0.052 (3.902)
Government-owned banks (GB) 2.017 (4.989)
Time 20.971*** (2.893) 12.356*** (4.904) 15.289*** (5.379)
CR ?Time 10.448** (4.521) 8.371* (4.585) 8.066* (4.614)
SP ?Time ?8.036** (3.815) ?6.046 (3.980) ?5.449 (4.048)
PM?Time ?12.747*** (3.843) ?12.736*** (3.944) ?12.952*** (3.971)
EBR ?Time 5.916 (4.446) 4.924 (4.527)
ORBA ?Time 7.435** (3.911) 7.241* (3.985)
GB ?Time ?5.655 (3.970)
Number of countries 53 53 53
Number of observations 482 482 482
Notes: This table reports the fndings from multivariate difference-in-difference regression; it
presents three regressions, where each column is a separate regression; the dependent variable, Bank
development, equals claims on the private sector by deposit money banks as a share of GDP; as
independent variables, we classify countries in the upper 30% greater stringency regulation and
supervision variables for each year as the treatment group, equals 1, and 0 otherwise; time is a dummy
variable indicating the period of 2007-2011 (after-crisis period), equals 1, and 0 otherwise; each
regression includes constant and control variables: legal origin dummy variables (English, French,
German and Socialist law), the religious composition (Catholic, Muslim and Protestant), latitude and
GDP per capita; the standard errors are in parentheses next to the estimated coeffcients; ***, **
and *indicate statistical signifcance at the 1, 5 and 10% levels, respectively
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associated with strong supervisory power in the pre-crisis and post-crisis periods.
Third, we fnd strong evidence that across different specifcation, there exist a positive
association between private monitoring framework and bank development in the
pre-crisis period; however, these market-based disciplinary mechanisms signifcantly
weaken development during the post-crisis period. Consistent with Cubillas et al. (2012),
our fndings suggest that it is less likely to foster the appropriate private market
incentive framework in a weak institutional environment where the private public
sector lacks the ability to monitor banks for ensuring bank development after a crisis.
Our results imply that good regulation can alleviate the unintended consequences of
private monitoring on bank development in an economic downturn[8]. In sum, we
support the goal of the frst and third pillars of the Basel II: capital requirements and
private monitoring with respect to bank development.
Furthermore, we fnd a strong association that restricting bank activities is
positively associated with bank development in the post-crisis period, suggesting that
restricting banks to engage in a broad range of activities strengthened bank
development in the post-crisis period. Countries with greater restrictiveness of bank
activities had higher levels of bank development than countries allowing bank activities
over the whole observation period of 1999-2011. This fnding supports the debate
regarding additional restrictions on bank activities. Bank development is particularly
important because researchers fnd that it is positively associated with economic growth
(Levine et al., 2000).
4.2 Multivariate DID regressions results: net interest margin
Results of the analysis between net interest margin and bank regulation are reported in
Table IV. We fnd that less stringent capital regulations are associated with greater
banking system effciency (as measured by low levels of interest margin) during the
pre-crisis period; however, this effect weakens in the post-crisis period. The relationship
is robust when controlling for other regulations. In addition, we do not fnd a strong
association between supervisory power and net interest margin, as well as private
monitoring and net interest margin. Finally, our analysis shows that high levels of
government ownership of banks are associated with reduced levels of bank effciency,
as measured by high levels of net interest margin in the post-crisis period. In general, our
fnding suggests that increasing capital requirements in Basel III will reduce bank
system effciency.
4.3 Multivariate DID regressions results: non-performing loans
Table Vindicate that coeffcients of CR are signifcantly negative, suggesting that more
stringent capital regulations in the pre-crisis period are associated with reduced bank
fragility. Upon inspection of SP?Time, we fnd signifcantly positive coeffcient values
(Models 2 and 3), indicating that powerful supervisors are associated with enhanced
levels of bank fragility in the post-crisis period. These results do not support the view
that granting broad powers to supervisors helps improve banking sector stability in the
post-crisis period. Finally, PM?Time coeffcients are found to be signifcantly positive,
indicating that empowering private-sector monitoring of banks is associated with
enhanced levels of bank fragility in the post-crisis period. This suggests that the private
public sector lacks the ability to monitor banks, ensuring bank stability in the post-crisis
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period. Furthermore, the coeffcient of PM in Model 2 is signifcantly negative,
indicating that strong private monitoring reduces bank fragility in the pre-crisis period.
Introducing the government-owned banks variable to the explanatory variable, we fnd
that this effect loses signifcance (Model 3). This observed effect may be the result of the
statistically negative correlation between private monitoring and government-owned
banks. This suggests that the private sector does not have an incentive to monitor
government-owned banks.
Examination of EBR yields signifcantly negative coeffcients, suggesting that
greater enter-into-banking requirements reduces bank fragility, as measured by
non-performing loans in the pre-crisis period. Finally, the coeffcient of ORBA and the
coeffcients of ORBA ? Time are signifcantly positive, suggesting that tighter
restrictions on banking activities increases bank fragility in both the pre-crisis and
post-crisis periods. These results do not support the debate regarding adding
restrictions on non-lending activities in an attempt to reduce bank fragility. In general,
low levels of bank fragility are associated with greater capital requirements, greater
entry into banking requirements, less restricting non-lending activities and lowlevels of
government ownership of banks over the whole period of 1999-2011. Our fndings are in
line with the goal of the frst pillar of the Basel II: capital requirements with respect to
bank fragility.
Table IV.
Multivariate
difference-in-
difference regression
analysis: net interest
margin
Department variable: net interest margin (1) (2) (3)
Capital regulation (CR) 0.755*** (0.195) 0.749*** (0.227) 0.785*** (0.227)
Supervisory power (SP) 0.212 (0.194) 0.202 (0.195) 0.158 (0.193)
Private monitoring (PM) 0.215 (0.183) 0.228 (0.186) 0.255 (0.187)
Entry-into-banking requirements (EBR) 0.078 (0.188) 0.069 (0.194)
Overall restrictions on bank activities (ORBA) 0.140 (0.174) 0.150 (0.175)
Government-owned banks (GB) 0.454** (0.234)
Time ?0.040 (0.172) 0.031 (0.302) 0.133 (0.351)
CR ?Time ?0.656** (0.276) ?0.645** (0.283) ?0.670*** (0.282)
SP ?Time 0.166 (0.234) 0.194 (0.246) 0.142 (0.248)
PM?Time 0.169 (0.235) 0.155 (0.243) 0.170 (0.242)
EBR ?Time ?0.101 (0.275) ?0.129 (0.277)
ORBA ?Time ?0.011 (0.241) ?0.093 (0.243)
GB ?Time 0.029 (0.242)
Number of countries 53 53 53
Number of observations 482 482 482
Notes: This table reports the fndings from multivariate difference-in-difference regression; it
presents three regressions, where each column is a separate regression; the dependent variable, Interest
margin, equals the value of a bank’s net interest revenue as a share of its average interest-bearing assets;
as independent variables, we classify country in the upper 30% greater stringency regulation and
supervision variables for each year as the treatment group, equals 1, and 0 otherwise; time is a dummy
variable indicating the period of 2007-2011 (after-crisis period), equals 1, and 0 otherwise; each
regression includes constant and control variables: legal origin dummy variables (English, French,
German and Socialist law), the religious composition (Catholic, Muslim and Protestant), latitude and
GDP per capita; the standard errors are in parentheses next to the estimated coeffcients; ***, ** and
* indicate statistical signifcance at the 1, 5 and 10% levels, respectively
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5. Conclusions and policy implications
We assess the changes of bank development, effciency and fragility and a country’s
regulation and supervisory practices, in terms of capital regulation, supervisory power,
private monitoring, entry into banking requirements, overall restrictions on bank
activities and government ownership of banks in a sample of 53 countries with a total of
482 observations over the period of 1999-2011. We use the multivariate DID regression
approach to control for potential endogeneity of the explanatory variables and
unobservable country-specifc effects.
In our empirical analysis, there is strong evidence that higher capital requirements
are associated with lower levels of bank fragility at the expense of reduced bank
effciency. Interestingly, we fnd evidence that strong capital regulatory requirements
enhance bank development and increase bank effciency in the post-crisis period. With
respect to the Basel II’s third pillar, we fnd evidence that supervisory practices that
strengthen private sector monitors of banks do help to improve bank development in the
pre-crisis period; however, this effect weakened in the post-crisis period. This suggests
that the private public sector lacks the ability to monitor banks for ensuring bank
development after a crisis. Furthermore, there is evidence that lower levels of bank
Table V.
Multivariate
difference-in-
difference regression
analysis: non-
performing loans
Department variable:
non-performing loans (1) (2) (3)
Capital regulation (CR) ?3.557*** (1.014) ?2.029** (0.988) ?1.823* (0.967)
Supervisory power (SP) 0.429 (0.895) 0.408 (0.849) ?0.0681 (0.838)
Private monitoring (PM) ?0.845 (0.834) ?0.316** (0.801) 0.101 (0.791)
Entry-into-banking requirements
(EBR) ?2.482*** (0.805) ?2.121*** (0.813)
Overall restrictions on bank
activities (ORBA) 2.163*** (0.749) 2.565*** (0.744)
Government-owned banks (GB) 4.519*** (0.958)
Time ?3.097*** (0.799) ?6.602*** (1.320) ?4.743*** (1.403)
CR ?Time 0.685 (1.284) ?0.452 (1.234) ?0.700 (1.206)
SP ?Time 0.680 (1.094) 2.403** (1.083) 2.168** (1.066)
PM?Time 2.066** (1.089) 1.977* (1.056) 1.864* (1.033)
EBR ?Time 1.535 (1.203) 0.936 (1.189)
ORBA ?Time 4.153*** (1.051) 3.314*** (1.041)
GB ?Time ?1.578 (1.037)
Number of countries 53 53 53
Number of observations 482 482 482
Notes: This table reports the fndings from multivariate difference-in-difference regression; it
presents three regressions, where each column is a separate regression; the dependent variable,
Non-performing loans, equals the ratio of defaulting loans due 90 days or more to total gross loans; as
independent variables, we classify country in the upper 30% greater stringency regulation and
supervision variables for each year as the treatment group, equals 1, and 0 otherwise; time is a dummy
variable indicating the period of 2007-2011 (after-crisis period), equals 1, and 0 otherwise; each
regression includes constant and control variables: legal origin dummy variables (English, French,
German and Socialist law), the religious composition (Catholic, Muslim and Protestant), latitude and
GDP per capita; the standard errors are in parentheses next to the estimated coeffcients; ***, **
and *indicate statistical signifcance at the 1, 5 and 10% levels, respectively
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fragility are associated with greater enter-into-banking requirements and less
restrictiveness on non-lending activities. However, less restrictiveness on non-lending
activities is associated with lower levels of bank development in the post-crisis period.
Finally, there is evidence that greater government ownership of banks is associated with
lower levels of bank effciency and high levels of bank fragility. Overall, our fndings
support Basel II’s frst and third pillars of higher capital requirements and market-based
disciplinary mechanisms but not the second pillar of the Basel II: stronger supervisory
authority.
Notes
1. In June 1999, the Basel Committee on Banking Supervision (BCBS) proposed a new capital
adequacy framework to replace Basel I, the Basel Capital Accord or the 1988 Accord, and
introduced Basel II in June 2004. The Basel II comprised three pillars: minimum capital
requirements, supervisory review and market discipline. In December 2010, the BCBS
proposed the Basel III and increased the requirements for capital, liquidity and global
systemically important fnancial institutions.
2. We fll in “gaps” in the survey data by making modest assumptions about the information in
prior and subsequent surveys and various bank outcomes during this period in our empirical
analysis. Specifcally, we use the information from Survey I to describe the regulatory
structure for 1999-2001, Survey II for 2002-2005, Survey III for 2006-2008 and Survey IV for
2009-2011.
3. Barth, Caprio and Levine aggregate the survey responses to individual questions and
construct various indexes of major categories of bank regulatory and supervisory practices.
Notice that we use all average scaled indexes which are calculated as an average of the
available questions’ responses to construct each index. Following Barth, Capiro and Levine,
we fll-in missing values, if there are responses to a question in at least two surveys (Survey
I, II or III) and these responses are the same, while the missing values for Survey IVare never
flled because of potential regulatory changes after the global fnancial crisis.
4. In the DID model, any country-specifc unobservable factors were removed in the frst stage
of estimating the difference across time. Next, any time trends are eliminated in the second
stage of calculating the difference across countries but within the same period under the
assumption that countries would have followed the same time trend. Finally, the DIDestimate
indicates the effect of the “treatment” being estimated to isolate from potential time- and
country-specifc confounding factors. Similarly, Rauch (2010) uses multivariate DID
methodology to examine the balance sheet fragility of state banks and national banks in the
pre-crisis period and during crisis period.
5. We classify countries in the upper 30 per cent of greater stringent bank regulatory and
supervisory practices as “the treatment group”, while countries in the lower 70 per cent of
greater stringent regulation are referred to as “the control group”.
6. LM test helps us decide models between a random-effects regression and a simple OLS
regression. Hausman specifcation test compares models between fxed effect and random
effect. These test statistics indicate that the random-effects model is the most appropriate in
this study.
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7. We further perform the joint signifcance test of regulation treatments and treatments with
interaction terms. For most regulations and supervisory practices, the joint tests confrm the
importance of both time and regulation treatments.
8. Similar to this viewthat bank regulation has a weak impact on bank outcomes between good
times and bad times, Anginer et al. (2014) fnd evidence that deposit insurance policy
destabilizes the banking system and exacerbates the problem of moral hazard in good times,
while the stabilization effect of deposit insurance dominates during the recent crisis.
References
Anginer, D., Demirgüç-Kunt, A. and Zhu, M. (2014), “Howdoes deposit insurance affect bank risk?
Evidence from the recent fnancial crisis”, Journal of Banking & Finance, Vol. 48,
pp. 312-321.
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world: a new database”, in Litan, R. and Herring, R. (Eds), Brookings-Wharton Papers on
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ihák, M., Demirgüç-Kunt, A., Martinez Peria, M.S. and Mohseni-Cheraghlou, A. (2012a), “Bank
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ihák, M., Demirgüç -Kunt, A. and Johnston, R.B. (2013), “Incentive audits: a new approach to
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Corresponding author
Wenling Lu can be contacted at: [email protected]
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doc_328256648.pdf
The purpose of this paper is to examine the impact of bank regulation and supervision on
bank development, efficiency and fragility over the period of 1999-2011.
Journal of Financial Economic Policy
Do bank regulation and supervision matter?: International evidence from the
recent financial crisis
Kangbok Lee Wenling Lu
Article information:
To cite this document:
Kangbok Lee Wenling Lu , (2015),"Do bank regulation and supervision matter?", J ournal of Financial
Economic Policy, Vol. 7 Iss 3 pp. 275 - 288
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Do bank regulation and
supervision matter?
International evidence from the recent
fnancial crisis
Kangbok Lee
Aviation and Supply Chain Management, Auburn University,
Auburn, Alabama, USA, and
Wenling Lu
Finance and Commercial Law, Western Michigan University,
Kalamazoo, Michigan, USA
Abstract
Purpose – The purpose of this paper is to examine the impact of bank regulation and supervision on
bank development, effciency and fragility over the period of 1999-2011.
Design/methodology/approach – The authors’ approach is based on a multivariate difference-
in-difference model which controls for potential endogeneity of the explanatory variables and
unobservable country-specifc effect. The paper investigates the changes of bank outcomes and a
country’s regulation and supervisory practices, in terms of capital regulation, supervisory power,
private monitoring, entry into banking requirements, overall restrictions on bank activities and
government ownership of banks in a sample of 53 countries with a total of 482 observations.
Findings – Empirical results indicate that greater capital regulatory requirements reduce bank
fragility, as measured by lower levels of non-performing loans but reduce bank effciency, as measured
by higher levels of net interest margin; supervisory practices that strengthen private sector monitoring
of banks improve bank development, as measured by bank private credit as a share of gross domestic
product; lower levels of non-performing loans are associated with greater enter-into-banking
requirements and less restrictiveness on bank activities; and greater government ownership of banks is
associated with both higher levels of net interest margin and higher levels of non-performing loans.
Overall, the fndings support Basel II’s frst and third pillars: capital requirements and private
monitoring.
Originality/value – This cross-country analysis provides evidence on which specifc regulatory and
supervisory practices work best in light of what was learned from the recent fnancial crisis.
Keywords Financial crisis, Financial institutions, Regulation and supervision
Paper type Research paper
1. Introduction
The global fnancial crisis of 2007-2009 was the most severe crisis since the Great
Depression, affecting banking systems in many countries. Kane (2009) argues that the
most important contributor to the fnancial crisis was a misguided regulatory
JEL classifcation – G38, G21, G28
The authors thank David Whidbee, Gene Lai, George Jiang and Que-Giang Tran-Thi for their
helpful comments and suggestions.
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/1757-6385.htm
Do bank
regulation and
supervision
matter?
275
Received17 March2015
Revised17 March2015
Accepted1 April 2015
Journal of Financial Economic
Policy
Vol. 7 No. 3, 2015
pp. 275-288
©Emerald Group Publishing Limited
1757-6385
DOI 10.1108/JFEP-03-2015-0019
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framework. Barth et al. (2012a) and C
?
ihák et al. (2012a and 2013) argue that weak
regulatory and supervisory frameworks contributed to the crisis and that
improvements to lessen the likelihood of another crisis can be made by such measures as
strengthening private monitoring incentives. In response to the recent fnancial crisis,
the regulatory reform agenda represented by Basel III as proposed by the Basel
Committee on Banking Supervision enhanced the level of complexity within the global
regulatory landscape[1]. However, it is not clear that the Basel III addresses the
fundamental cause of bank regulation failure.
There is a variety of different banking regulatory and supervisory structures and
some may be better-suited to improving bank development, performance and stability.
Importantly, newregulatory requirements will likely have a fundamental impact on the
shape of the business models that will be used by banks going forward. Our goal is to
empirically analyze the different regulatory and supervisory approaches in countries
around the world, and determine which approaches work best at improving bank
development, performance and stability. We address this issue by asking the questions:
Did regulation and supervision in some countries make a difference in terms of bank
development, effciency and fragility? To what extent have differential bank outcomes
in countries with greater stringency as regard bank regulatory and supervisory
practices led to changes? How was the performance of banks associated with stricter
bank regulation impacted before the fnancial crisis, during and after the fnancial
crisis? Answers to all of these important questions should be helpful to regulatory
policymakers in countries everywhere, as they consider and implement fnancial
reforms.
In general, our multivariate difference-in-difference (DID) regression results indicate
that in the pre-crisis period:
• greater capital regulatory requirements reduce bank fragility, as measured by
lower levels of non-performing loans but reduce bank effciency, as measured by
higher levels of net interest margin;
• supervisory practices that strengthen private sector monitoring of banks improve
bank development, as measured by bank private credit as a share of gross
domestic product (GDP);
• lower levels of non-performing loans are associated with greater
enter-into-banking requirements and less restrictiveness on bank activities; and
• greater government ownership of banks is associated with both higher levels of
net interest margin and higher levels of non-performing loans.
Interestingly, we fnd evidence that greater capital regulatory requirements enhance
bank development and increase bank effciency in the post-crisis period. Furthermore,
there is strong evidence that greater private monitoring is associated with lower levels
of bank development and higher levels of non-performing loans, suggesting that it is
less likely to foster the appropriate private market incentive framework in a weak
institutional environment where the private public sector lacks the ability to monitor
banks to better ensure bank development and stability after a crisis. Finally, greater
restrictiveness on bank activities is associated with higher levels of bank development,
but with higher levels of non-performing loans in the post-crisis period.
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Our cross-country analysis provides evidence on which specifc regulatory and
supervisory practices work best in light of what was learned from the recent fnancial
crisis. Overall, the fndings support Basel II’s frst and third pillars of the capital
requirement and market-based disciplinary mechanisms. Moreover, stronger capital
requirements further enhance bank development, but market discipline or private
monitoring practices weaken development in the post-crisis period. The paper
contributes to the ongoing debate regarding appropriate regulatory reforms in the
banking industry to promote global fnancial stability by shedding additional light on
the extent to which the current regulatory and supervisory frameworks have an impact
on bank development, effciency and fragility.
The paper proceeds as follows. In Section 2, we review related literature on
regulatory and supervisory practices. Section 3 describes and discusses the data and
methodology used in our empirical analysis. Section 4 presents and discusses the results
of our analysis. Section 5 provides conclusions.
2. Literature review
There have been relatively limited data available on bank regulation and supervision
around the world. However, Barth et al. (2001) recently have provided the frst
comprehensive database to cover a wide range of characteristics associated with bank
regulation and supervision worldwide based on a survey of 117 national bank
regulatory and supervisory authorities. A limited amount of research has analyzed
bank regulation differences across countries and how they relate to bank development,
effciency and fragility. An important exception is the work of Barth et al. (2004), who,
for example, conclude that countries with bank policies that strengthen private
monitoring are associated with better bank development and performance. However, no
signifcant associations are found between stringent capital requirements, offcial
supervisory power, government ownership of banks and bank performance and
development, when controlling for other features of bank regulation and supervision.
Furthermore, Barth et al. (2008) point out that countries did not signifcantly change
their regulatory and supervisory structures suffciently for the better over the period of
1999-2008. However, it is not clear that these conclusions hold in the context of the recent
fnancial crisis. Therefore, we build on their work by examining whether the
relationships between banking development, bank performance and bank regulation
and supervision have changed in response to the recent global fnancial crisis.
Although Barth et al. (2012b) assess the relationship between regulatory and
supervisory practices and bank performance for Survey I in 1999 and Survey IVin 2011,
our cross-country analysis differs from theirs along the following dimensions. First,
unlike their analysis using data at one point in time, our analysis uses time-series data
over the period of 1999-2011. This allows us to identify trends and examine the evolution
of bank regulations over time[2] as well as increase our model’s explanatory power due
to a larger sample. Second, to illustrate how strengthened bank regulation and
supervision is related to bank performance, we classify a country in the upper 30 per
cent of strengthened bank regulatory and supervisory practices as “the treatment
group.” This allows us to compare the impact of bank regulation between two groups:
countries with either strong or weak regulations. Third, adding a time dummy allows us
to separate the impacts of bank regulation on bank outcomes during the pre-crisis and
post-crisis periods. Last but not least, we use multivariate DIDregression models which
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allow us to determine to what extent the regulatory and supervisory practices are
responsible for the observed changes in outcomes, compared to their studies which rely
on ordinary least squares regressions using each survey.
3. Data, methodology and explanatory variables
3.1 Data
The main bank regulatory and supervisory data used in this study are unique and are
becoming more widely used in banking research (see Barth et al., 2006, 2013, for a
detailed analysis and a detailed description of the construction of the indexes). We focus
on Basel III’s three pillars and three major indexes, introduced in the next section, in this
study[3]. The data on global fnancial indicators are from the World Bank Global
Financial Development Database (C
?
ihák et al., 2012b). The fnal sample is an unbalanced
panel with a total of 482 observations across 53 countries.
3.2 Variable defnitions
We discuss the variables used in the cross-country specifcations in this section. As
dependent variables, frst, we use bank development measured by bank private credit as
a share of GDP. It measures the level of fnancial development and refects the
intermediation of society’s savings into private sector credit. Second, bank effciency is
measured by net interest margin, representing the value of a bank’s net interest revenue
as a share of its average interest-bearing assets. Higher levels of net interest margins can
indicate banking sector ineffciency or greater market power or lower competitive
structure of the market that allows banks to earn higher margins. Third, bank stability
is measured by non-performing loans, representing the ratio of defaulting loans due 90
days or more to total gross loans. Higher levels of non-performing loans indicate lower
levels of loan quality, higher levels of bank fragility or corruption in lending.
As explanatory variables, we use six measures of the structure of bank regulation
and supervision. First, Capital Regulation (CR): Basel II’s Pillar 1, an index of the
stringency of bank capital requirements. It measures the extent of regulatory
requirements regarding the amount and the source of capital and whether the
authorities verify the source of capital (range: 0-10, with higher values indicating greater
stringency). Second, Supervisory Power (SP): Basel II’s Pillar 2, is an index of the power
of the offcial supervisory authorities. It measures the extent to which the authorities
have the power to take specifc actions to prevent and correct problems (range: 0-14, with
higher values indicating greater power). Third, Private Monitoring (PM): Basel II’s Pillar
3, is an index that measures the degree to whether there are incentives and ability for the
private sector to monitor banks (range: 0-12, with higher values indicating greater
private monitoring). Fourth, Entry into Banking Requirements (EBR), is an index of
regulatory entry barriers. It measures the strictness of specifc legal requirements for
obtaining a license to operate as a bank (range: 0-8, with higher values indicating greater
stringency). Fifth, Overall Restrictions on Bank Activities (ORBA), is an index of
regulatory restrictions of bank activities. It measures the limitations on the ability of
banks to engage in securities, insurance and real estate activities, and to own and control
non-fnancial frms (range: 4-16, with higher values indicating greater restrictiveness).
Sixth, Government-Owned Banks (GB), is the per cent of the banking system’s assets
government-owned.
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As control variables, we take into account a number of country-specifc
characteristics. La Porta et al. (1998 and 1999) and Djankov et al. (2007 and 2008) fnd
that historically determined differences in legal origin help explain the differences in
fnancial development worldwide. Some studies also suggest that religious composition
and latitudinal distance from the equator infuence fnancial development (Stulz and
Williamson, 2003; Beck et al., 2003). Therefore, we include legal origin dummy variables
(English Common Law, German Civil Law, French Civil Law and Socialist Law); the
fraction of the population that is Catholic, Muslim and Protestant; and latitude in our
analysis. Furthermore, given that recent crises display some important differences from
earlier crises, and have been concentrated in advanced economies with large and
integrated fnancial systems (Laeven and Valencia, 2012 and 2013), we control for the
level of economic development in each country. We also include GDP per capita to
control for the level of economic development in each country.
Table I provides summary statistics for our selected variables. Countries in the upper
30 per cent of strengthened capital regulation, greater supervisory power, greater
private monitoring, greater entry into banking requirements, greater restrictions on
bank activities and greater government ownership of banks (countries in the treatment
group) account for 25.8, 33.1, 43.1, 71.0, 54.4 and 36.7 per cent, of our sample,
respectively.
Table I.
Summary statistics
Variable Mean SD Minimum Maximum
No. of
observations
Dependent variables
Bank development 76.299 50.273 9.617 269.280 482
Net interest margin 3.147 2.088 ?3.662 12.342 482
Non-performing loans 6.111 6.975 0.100 45.200 482
Treatments
Capital regulation 0.258 0.438 0 1 482
Supervisory power 0.331 0.471 0 1 482
Private monitoring 0.431 0.495 0 1 482
Entry-into-banking requirements 0.710 0.454 0 1 482
Overall restrictions on bank activities 0.544 0.498 0 1 482
Government-owned banks 0.367 0.483 0 1 482
Notes: This table reports summary statistics for the variables we use in our estimation; mean,
standard deviation, minimum, maximumand the number of observations values are displayed; the full
sample contains 53 countries and 482 observations over the period of 1999-2011; these 53 countries are:
Argentina, Australia, Austria, Belgium, Brazil, Canada, China, Colombia, Croatia, Czech Republic,
Denmark, Finland, France, Germany, Greece, Hong Kong, Hungary, Iceland, India, Indonesia, Ireland,
Israel, Italy, Japan, Kazakhstan, Kenya, Korea, Latvia, Lithuania, Luxembourg, Malaysia, Mexico,
Morocco, The Netherlands, Nigeria, Norway, Pakistan, Peru, Philippines, Poland, Portugal, Russia,
Singapore, Slovenia, South Africa, Spain, Sweden, Switzerland, Thailand, Turkey, Ukraine, the United
Kingdom and the United States; variable defnition: Bank development equals claims on the private
sector by deposit money banks as a share of GDP; Interest margin equals the value of a bank’s net
interest revenue as a share of its average interest-bearing assets; Non-performing loans equals the ratio
of defaulting loans due 90 days or more to total gross loans; countries in the treatment group are
countries in the upper 30% greater stringency regulation and supervision variables
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Table II provides the correlation matrix for the variables used in our analysis. These
correlation results are informative. First, greater bank development is signifcantly
correlated with less supervisory power, lower governmental ownership of banks and
fewer bank activity restrictions. Similarly, more effcient banking systems, as measured
by lower levels of net interest margin, are signifcantly correlated with less supervisory
power, lower government ownership of banks, fewer restrictions on bank activities and
fewer entry-into-banking requirements. Finally, bank fragility, as measured by higher
levels of non-performing loans, is signifcantly associated with weaker private
monitoring, stronger supervisory power, lower government ownership of banks and
greater restrictions on bank activities. However, these results do not take into account
other aspects of regulation and supervision due to their bivariate nature. Although some
regulatory and supervisory variables are signifcantly correlated with each other, some
of these correlations are relatively low. This suggests that it is important to consider a
broader variety of regulations and supervisory practices in assessing bank
development, effciency and fragility.
3.3 Methodology
We use Bank Regulation and Supervision Surveys to directly assess the differential
effect of bank regulation and supervision on bank development, effciency and fragility
in a sample of 53 countries during the period of 1999-2011. We implement a multivariate
DIDapproach to assess the change in bank outcomes in the pre-crisis and post-crisis for
weak and strong country-level bank regulation[4]. The regression model is expressed as
follows:
Y
it
? ?
0
? ?
1
CR
it
? ?
2
SP
it
? ?
3
PM
it
? ?
4
EBR
it
? ?
5
ORBA
it
? ?
6
GB
it
? ?
7
Time
? ?
8
CR
it
? Time ? ?
9
SP
it
? Time ? ?
10
PM
it
? Time ? ?
11
EBR
it
? Time
? ?
12
ORBA
it
? Time ? ?
13
GB
it
? Time ? ?X
it
? u
i
? ?
it
Where i, t refer to country and year, respectively. Y
it
is the dependent variables in
country i in year t. Time is a dummy variable that takes a value of one after the recent
fnancial crisis (year 2007-2011) and 0 before the recent fnancial crisis (year 1999-2006).
CR
it
, SP
it
, PM
it
, EBR
it
, ORBA
it
and GB
it
is a dummy variable in country i in year t that
takes a value of one if countries are in the treatment group and 0 if they are in the control
group[5]. X
it
is a set of variables to control for specifc characteristics in country i in year
t, described in the previous section. u
i
is all the country-specifc variation that is stable
over time. ?
it
is the error term. We identify the most suitable statistical models (pooling,
random effect or fxed effect) in our analysis by conducting two post-estimation tests:
the Breusch–Pagan Lagrangian multiplier (LM) and Hausman specifcation[6].
In our specifcation, the coeffcients for various bank regulation and supervision
practices measure the importance of regulation in the pre-crisis period. The coeffcients
for the interaction between regulation and time dummy show by how much the stricter
regulation countries (treatment group) changed compared to the less strict regulation
countries (control group) and compared to the pre-crisis period. As lower values of net
interest margin indicate higher levels of bank effciency and lower values of
non-performing loans indicate lower levels of bank fragility, the positive impact of
greater bank regulation in the pre-crisis period would imply a negative coeffcient for
these variables. Weakening (enhancing) impact of bank regulation after the recent crisis
JFEP
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280
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281
Do bank
regulation and
supervision
matter?
D
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would imply a positive (negative) coeffcient for the interaction between each of bank
regulation and the time dummy variable. However, the interpretation of the coeffcients
of bank development would be opposite compared to the one described earlier, as higher
values of bank development indicate higher levels of fnancial development[7].
4. Empirical results
4.1 Multivariate DID regressions results: bank development
We add the explanatory variables sets successively, starting with only three pillars of
the Basel II (Model 1). Model 2 adds both entry-into-banking requirements and overall
restrictions on bank activities. Model 3 includes government ownership of banks. The
results of bank development and bank regulatory and supervisory practices are shown
in Table III. First, we fnd a weak association between capital regulation and bank
development during the pre-crisis period; however, analysis of the post-crisis period
shows that strong capital regulation enhances bank development. In general, our results
show that, in total, bank development is positively associated with strong capital
requirements. This link is robust after simultaneously controlling for a broad aspect of
regulations. Second, we fnd weak evidence that bank development is negatively
Table III.
Multivariate
difference-in-
difference regression
analysis: bank
development
Department variable: bank
development (1) (2) (3)
Capital regulation (CR) ?3.45 (3.58) ?1.290 (3.697) ?1.424 (3.727)
Supervisory power (SP) ?0.611 (3.186) ?0.508 (3.186) ?1.002 (3.232)
Private monitoring (PM) 5.581* (3.019) 5.816** (3.055) 6.408** (3.095)
Entry-into-banking requirements
(EBR) ?3.505 (3.094) ?2.315 (4.217)
Overall restrictions on bank
activities (ORBA) ?0.601 (2.849) 0.052 (3.902)
Government-owned banks (GB) 2.017 (4.989)
Time 20.971*** (2.893) 12.356*** (4.904) 15.289*** (5.379)
CR ?Time 10.448** (4.521) 8.371* (4.585) 8.066* (4.614)
SP ?Time ?8.036** (3.815) ?6.046 (3.980) ?5.449 (4.048)
PM?Time ?12.747*** (3.843) ?12.736*** (3.944) ?12.952*** (3.971)
EBR ?Time 5.916 (4.446) 4.924 (4.527)
ORBA ?Time 7.435** (3.911) 7.241* (3.985)
GB ?Time ?5.655 (3.970)
Number of countries 53 53 53
Number of observations 482 482 482
Notes: This table reports the fndings from multivariate difference-in-difference regression; it
presents three regressions, where each column is a separate regression; the dependent variable, Bank
development, equals claims on the private sector by deposit money banks as a share of GDP; as
independent variables, we classify countries in the upper 30% greater stringency regulation and
supervision variables for each year as the treatment group, equals 1, and 0 otherwise; time is a dummy
variable indicating the period of 2007-2011 (after-crisis period), equals 1, and 0 otherwise; each
regression includes constant and control variables: legal origin dummy variables (English, French,
German and Socialist law), the religious composition (Catholic, Muslim and Protestant), latitude and
GDP per capita; the standard errors are in parentheses next to the estimated coeffcients; ***, **
and *indicate statistical signifcance at the 1, 5 and 10% levels, respectively
JFEP
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(
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T
)
associated with strong supervisory power in the pre-crisis and post-crisis periods.
Third, we fnd strong evidence that across different specifcation, there exist a positive
association between private monitoring framework and bank development in the
pre-crisis period; however, these market-based disciplinary mechanisms signifcantly
weaken development during the post-crisis period. Consistent with Cubillas et al. (2012),
our fndings suggest that it is less likely to foster the appropriate private market
incentive framework in a weak institutional environment where the private public
sector lacks the ability to monitor banks for ensuring bank development after a crisis.
Our results imply that good regulation can alleviate the unintended consequences of
private monitoring on bank development in an economic downturn[8]. In sum, we
support the goal of the frst and third pillars of the Basel II: capital requirements and
private monitoring with respect to bank development.
Furthermore, we fnd a strong association that restricting bank activities is
positively associated with bank development in the post-crisis period, suggesting that
restricting banks to engage in a broad range of activities strengthened bank
development in the post-crisis period. Countries with greater restrictiveness of bank
activities had higher levels of bank development than countries allowing bank activities
over the whole observation period of 1999-2011. This fnding supports the debate
regarding additional restrictions on bank activities. Bank development is particularly
important because researchers fnd that it is positively associated with economic growth
(Levine et al., 2000).
4.2 Multivariate DID regressions results: net interest margin
Results of the analysis between net interest margin and bank regulation are reported in
Table IV. We fnd that less stringent capital regulations are associated with greater
banking system effciency (as measured by low levels of interest margin) during the
pre-crisis period; however, this effect weakens in the post-crisis period. The relationship
is robust when controlling for other regulations. In addition, we do not fnd a strong
association between supervisory power and net interest margin, as well as private
monitoring and net interest margin. Finally, our analysis shows that high levels of
government ownership of banks are associated with reduced levels of bank effciency,
as measured by high levels of net interest margin in the post-crisis period. In general, our
fnding suggests that increasing capital requirements in Basel III will reduce bank
system effciency.
4.3 Multivariate DID regressions results: non-performing loans
Table Vindicate that coeffcients of CR are signifcantly negative, suggesting that more
stringent capital regulations in the pre-crisis period are associated with reduced bank
fragility. Upon inspection of SP?Time, we fnd signifcantly positive coeffcient values
(Models 2 and 3), indicating that powerful supervisors are associated with enhanced
levels of bank fragility in the post-crisis period. These results do not support the view
that granting broad powers to supervisors helps improve banking sector stability in the
post-crisis period. Finally, PM?Time coeffcients are found to be signifcantly positive,
indicating that empowering private-sector monitoring of banks is associated with
enhanced levels of bank fragility in the post-crisis period. This suggests that the private
public sector lacks the ability to monitor banks, ensuring bank stability in the post-crisis
283
Do bank
regulation and
supervision
matter?
D
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period. Furthermore, the coeffcient of PM in Model 2 is signifcantly negative,
indicating that strong private monitoring reduces bank fragility in the pre-crisis period.
Introducing the government-owned banks variable to the explanatory variable, we fnd
that this effect loses signifcance (Model 3). This observed effect may be the result of the
statistically negative correlation between private monitoring and government-owned
banks. This suggests that the private sector does not have an incentive to monitor
government-owned banks.
Examination of EBR yields signifcantly negative coeffcients, suggesting that
greater enter-into-banking requirements reduces bank fragility, as measured by
non-performing loans in the pre-crisis period. Finally, the coeffcient of ORBA and the
coeffcients of ORBA ? Time are signifcantly positive, suggesting that tighter
restrictions on banking activities increases bank fragility in both the pre-crisis and
post-crisis periods. These results do not support the debate regarding adding
restrictions on non-lending activities in an attempt to reduce bank fragility. In general,
low levels of bank fragility are associated with greater capital requirements, greater
entry into banking requirements, less restricting non-lending activities and lowlevels of
government ownership of banks over the whole period of 1999-2011. Our fndings are in
line with the goal of the frst pillar of the Basel II: capital requirements with respect to
bank fragility.
Table IV.
Multivariate
difference-in-
difference regression
analysis: net interest
margin
Department variable: net interest margin (1) (2) (3)
Capital regulation (CR) 0.755*** (0.195) 0.749*** (0.227) 0.785*** (0.227)
Supervisory power (SP) 0.212 (0.194) 0.202 (0.195) 0.158 (0.193)
Private monitoring (PM) 0.215 (0.183) 0.228 (0.186) 0.255 (0.187)
Entry-into-banking requirements (EBR) 0.078 (0.188) 0.069 (0.194)
Overall restrictions on bank activities (ORBA) 0.140 (0.174) 0.150 (0.175)
Government-owned banks (GB) 0.454** (0.234)
Time ?0.040 (0.172) 0.031 (0.302) 0.133 (0.351)
CR ?Time ?0.656** (0.276) ?0.645** (0.283) ?0.670*** (0.282)
SP ?Time 0.166 (0.234) 0.194 (0.246) 0.142 (0.248)
PM?Time 0.169 (0.235) 0.155 (0.243) 0.170 (0.242)
EBR ?Time ?0.101 (0.275) ?0.129 (0.277)
ORBA ?Time ?0.011 (0.241) ?0.093 (0.243)
GB ?Time 0.029 (0.242)
Number of countries 53 53 53
Number of observations 482 482 482
Notes: This table reports the fndings from multivariate difference-in-difference regression; it
presents three regressions, where each column is a separate regression; the dependent variable, Interest
margin, equals the value of a bank’s net interest revenue as a share of its average interest-bearing assets;
as independent variables, we classify country in the upper 30% greater stringency regulation and
supervision variables for each year as the treatment group, equals 1, and 0 otherwise; time is a dummy
variable indicating the period of 2007-2011 (after-crisis period), equals 1, and 0 otherwise; each
regression includes constant and control variables: legal origin dummy variables (English, French,
German and Socialist law), the religious composition (Catholic, Muslim and Protestant), latitude and
GDP per capita; the standard errors are in parentheses next to the estimated coeffcients; ***, ** and
* indicate statistical signifcance at the 1, 5 and 10% levels, respectively
JFEP
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284
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:
5
2
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(
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T
)
5. Conclusions and policy implications
We assess the changes of bank development, effciency and fragility and a country’s
regulation and supervisory practices, in terms of capital regulation, supervisory power,
private monitoring, entry into banking requirements, overall restrictions on bank
activities and government ownership of banks in a sample of 53 countries with a total of
482 observations over the period of 1999-2011. We use the multivariate DID regression
approach to control for potential endogeneity of the explanatory variables and
unobservable country-specifc effects.
In our empirical analysis, there is strong evidence that higher capital requirements
are associated with lower levels of bank fragility at the expense of reduced bank
effciency. Interestingly, we fnd evidence that strong capital regulatory requirements
enhance bank development and increase bank effciency in the post-crisis period. With
respect to the Basel II’s third pillar, we fnd evidence that supervisory practices that
strengthen private sector monitors of banks do help to improve bank development in the
pre-crisis period; however, this effect weakened in the post-crisis period. This suggests
that the private public sector lacks the ability to monitor banks for ensuring bank
development after a crisis. Furthermore, there is evidence that lower levels of bank
Table V.
Multivariate
difference-in-
difference regression
analysis: non-
performing loans
Department variable:
non-performing loans (1) (2) (3)
Capital regulation (CR) ?3.557*** (1.014) ?2.029** (0.988) ?1.823* (0.967)
Supervisory power (SP) 0.429 (0.895) 0.408 (0.849) ?0.0681 (0.838)
Private monitoring (PM) ?0.845 (0.834) ?0.316** (0.801) 0.101 (0.791)
Entry-into-banking requirements
(EBR) ?2.482*** (0.805) ?2.121*** (0.813)
Overall restrictions on bank
activities (ORBA) 2.163*** (0.749) 2.565*** (0.744)
Government-owned banks (GB) 4.519*** (0.958)
Time ?3.097*** (0.799) ?6.602*** (1.320) ?4.743*** (1.403)
CR ?Time 0.685 (1.284) ?0.452 (1.234) ?0.700 (1.206)
SP ?Time 0.680 (1.094) 2.403** (1.083) 2.168** (1.066)
PM?Time 2.066** (1.089) 1.977* (1.056) 1.864* (1.033)
EBR ?Time 1.535 (1.203) 0.936 (1.189)
ORBA ?Time 4.153*** (1.051) 3.314*** (1.041)
GB ?Time ?1.578 (1.037)
Number of countries 53 53 53
Number of observations 482 482 482
Notes: This table reports the fndings from multivariate difference-in-difference regression; it
presents three regressions, where each column is a separate regression; the dependent variable,
Non-performing loans, equals the ratio of defaulting loans due 90 days or more to total gross loans; as
independent variables, we classify country in the upper 30% greater stringency regulation and
supervision variables for each year as the treatment group, equals 1, and 0 otherwise; time is a dummy
variable indicating the period of 2007-2011 (after-crisis period), equals 1, and 0 otherwise; each
regression includes constant and control variables: legal origin dummy variables (English, French,
German and Socialist law), the religious composition (Catholic, Muslim and Protestant), latitude and
GDP per capita; the standard errors are in parentheses next to the estimated coeffcients; ***, **
and *indicate statistical signifcance at the 1, 5 and 10% levels, respectively
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fragility are associated with greater enter-into-banking requirements and less
restrictiveness on non-lending activities. However, less restrictiveness on non-lending
activities is associated with lower levels of bank development in the post-crisis period.
Finally, there is evidence that greater government ownership of banks is associated with
lower levels of bank effciency and high levels of bank fragility. Overall, our fndings
support Basel II’s frst and third pillars of higher capital requirements and market-based
disciplinary mechanisms but not the second pillar of the Basel II: stronger supervisory
authority.
Notes
1. In June 1999, the Basel Committee on Banking Supervision (BCBS) proposed a new capital
adequacy framework to replace Basel I, the Basel Capital Accord or the 1988 Accord, and
introduced Basel II in June 2004. The Basel II comprised three pillars: minimum capital
requirements, supervisory review and market discipline. In December 2010, the BCBS
proposed the Basel III and increased the requirements for capital, liquidity and global
systemically important fnancial institutions.
2. We fll in “gaps” in the survey data by making modest assumptions about the information in
prior and subsequent surveys and various bank outcomes during this period in our empirical
analysis. Specifcally, we use the information from Survey I to describe the regulatory
structure for 1999-2001, Survey II for 2002-2005, Survey III for 2006-2008 and Survey IV for
2009-2011.
3. Barth, Caprio and Levine aggregate the survey responses to individual questions and
construct various indexes of major categories of bank regulatory and supervisory practices.
Notice that we use all average scaled indexes which are calculated as an average of the
available questions’ responses to construct each index. Following Barth, Capiro and Levine,
we fll-in missing values, if there are responses to a question in at least two surveys (Survey
I, II or III) and these responses are the same, while the missing values for Survey IVare never
flled because of potential regulatory changes after the global fnancial crisis.
4. In the DID model, any country-specifc unobservable factors were removed in the frst stage
of estimating the difference across time. Next, any time trends are eliminated in the second
stage of calculating the difference across countries but within the same period under the
assumption that countries would have followed the same time trend. Finally, the DIDestimate
indicates the effect of the “treatment” being estimated to isolate from potential time- and
country-specifc confounding factors. Similarly, Rauch (2010) uses multivariate DID
methodology to examine the balance sheet fragility of state banks and national banks in the
pre-crisis period and during crisis period.
5. We classify countries in the upper 30 per cent of greater stringent bank regulatory and
supervisory practices as “the treatment group”, while countries in the lower 70 per cent of
greater stringent regulation are referred to as “the control group”.
6. LM test helps us decide models between a random-effects regression and a simple OLS
regression. Hausman specifcation test compares models between fxed effect and random
effect. These test statistics indicate that the random-effects model is the most appropriate in
this study.
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7. We further perform the joint signifcance test of regulation treatments and treatments with
interaction terms. For most regulations and supervisory practices, the joint tests confrm the
importance of both time and regulation treatments.
8. Similar to this viewthat bank regulation has a weak impact on bank outcomes between good
times and bad times, Anginer et al. (2014) fnd evidence that deposit insurance policy
destabilizes the banking system and exacerbates the problem of moral hazard in good times,
while the stabilization effect of deposit insurance dominates during the recent crisis.
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Corresponding author
Wenling Lu can be contacted at: [email protected]
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